Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities
We derive the optimal investment policy of a risk-averse investor in a market where there is a textbook arbitrage opportunity, but where liabilities must be secured by collateral. We find that it is often optimal to underinvest in the arbitrage by taking a smaller position than collateral constraints allow. Even when the optimal policy is followed, the arbitrage portfolio typically experiences losses before the final convergence date. In fact, its initial performance may be indistinguishable from that of a conventional portfolio with a poor track record. These results have important implications for the role of arbitrageurs in financial markets. Copyright 2004, Oxford University Press.
Volume (Year): 17 (2004)
Issue (Month): 3 ()
|Contact details of provider:|| Postal: Oxford University Press, Journals Department, 2001 Evans Road, Cary, NC 27513 USA.|
Web page: http://www.rfs.oupjournals.org/
More information through EDIRC
|Order Information:||Web: http://www4.oup.co.uk/revfin/subinfo/|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Jean-Pierre Zigrand, 1999. "Arbitrage and Endogenous Market Integration," FMG Discussion Papers dp319, Financial Markets Group.
- Ball, Clifford A. & Torous, Walter N., 1983. "Bond Price Dynamics and Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 18(04), pages 517-531, December.
- Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
- Shleifer, Andrei & Vishny, Robert W, 1997.
" The Limits of Arbitrage,"
Journal of Finance,
American Finance Association, vol. 52(1), pages 35-55, March.
- Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
- Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
- Longstaff, Francis A, 1995. "Option Pricing and the Martingale Restriction," Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 1091-1124.
- Basak, Suleyman & Croitoru, Benjamin, 2000. "Equilibrium Mispricing in a Capital Market with Portfolio Constraints," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 715-748.
- Suleyman Basak & Benjamin Croitoru, "undated". "Equilibrium Mispricing in a Capital Market with Portfolio Constraints," Rodney L. White Center for Financial Research Working Papers 17-99, Wharton School Rodney L. White Center for Financial Research.
- Chen Zhiwu, 1995. "Financial Innovation and Arbitrage Pricing in Frictional Economies," Journal of Economic Theory, Elsevier, vol. 65(1), pages 117-135, February.
- Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Carl Ackermann & Richard McEnally & David Ravenscraft, 1999. "The Performance of Hedge Funds: Risk, Return, and Incentives," Journal of Finance, American Finance Association, vol. 54(3), pages 833-874, 06.
- Willard, Gregory A & Dybvig, Philip H, 1999. "Empty Promises and Arbitrage," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 807-834.
- Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-180.
- Hindy, Ayman, 1995. "Viable prices in financial markets with solvency constraints," Journal of Mathematical Economics, Elsevier, vol. 24(2), pages 105-135.
- De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
- J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, "undated". "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
- De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
- Mark Grinblatt & Francis A. Longstaff, 2000. "Financial Innovation and the Role of Derivative Securities: An Empirical Analysis of the Treasury STRIPS Program," Journal of Finance, American Finance Association, vol. 55(3), pages 1415-1436, 06.
- Brennan, Michael J & Schwartz, Eduardo S, 1990. "Arbitrage in Stock Index Futures," The Journal of Business, University of Chicago Press, vol. 63(1), pages 7-31, January.
- Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
- Tuckman, Bruce & Vila, Jean-Luc, 1992. " Arbitrage with Holding Costs: A Utility-Based Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1283-1302, September. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:oup:rfinst:v:17:y:2004:i:3:p:611-641. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Oxford University Press)or (Christopher F. Baum)
If references are entirely missing, you can add them using this form.